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Quarterly statement from Australia's RBA

Quarterly statement from Australia's RBA raised inflation forecast; focus is on weaker growth

The Reserve Bank today released its eagerly awaited Statement on Monetary Policy, which comes after the RBA's most aggressive policy easing since the 1990-91 recession - the RBA has slashed the cash rate by a colossal 200bp in just 9 weeks, having hiked the cash rate as recently as March. Today's statement explained in greater detail the main reason for this unexpectedly assertive easing - the onset of the global financial crisis, which significantly altered the balance of risks and, therefore, required an "unusually large" policy response.

Today's statement, while lowering the GDP growth forecast, raised the medium term inflation profile. Back in the August statement, the forecast was that inflation would be above target until late 2010 - now, RBA officials do not expect inflation to be back within the 2-3% target range until 2011. The clear message from the fact that the RBA is slashing the cash rate as inflation accelerates is that inflation no longer is the name of the policy game. RBA officials clearly are anxious to avoid "an unduly sharp weakening in demand" in the context that inflation is assumed to return to target over time. The RBA is tolerating high inflation to focus on cushioning the downside for growth.

Today's statement outlined in detail why RBA officials acted so assertively to the neutralise the policy stance in recent months. Apart from the decisive shift in the balance of risks as a result of the worsening global financial market conditions, the statement outlined the key changes in macro-economic conditions. The RBA now expects lower global GDP growth and inflation, while falling commodity prices mean the terms of trade boom finally is over. In fact, today's statement makes clear that the terms of trade will likely "subtract noticeably from national income growth". Before, the terms of trade was a powerful source of support for national income.

On the domestic economy, the RBA's statement highlighted the slowdown in growth in household spending, lower borrowing by both households and businesses, weaker conditions in the labour market, and what officials expect to be a significant scaling back of previously upbeat business investment plans. Our research suggests that, already, there is accumulating evidence that firms in mining, in particular, have become much more cautious about their expansion plans. Importantly, the RBA also highlighted today the difficulty some firms are having in obtaining credit. In our view, this will remain a significant impediment to business spending for some time.

Importantly, today's statement lowered the official GDP growth forecasts, as we expected. In fact, the RBA probably was keen to avoid a conflict with the Government's revised Budget forecasts, which also show a lower official growth forecast. The RBA's forecast now is that the economy will grow by just 1.5% in the year to June 2009, a reduction of 0.75% points from the previous forecast released back in August. On inflation, the RBA now forecast that inflation will remain above target beyond the end of 2009. The official forecasts show inflation still at 3% at the end of 2010, but back at 2.5% by mid 2011 - six months later than under the August forecasts. The official forecast is for core inflation to be at 4% in June 2009, well above the headline measure, which should be tracking close to 3%

Clearly, the RBA has acted decisively to return policy to a broadly neutral stance as quickly as possible - obviously, with the outlook seemingly darkening by the day, the previously tight stance of policy no longer was appropriate. With the policy stance now neutral, we have reached the end of the beginning of this easing cycle. From here, officials will push the policy stance decisively into easy territory in order to cushion the expected downside for the economy. Having acted so assertively over the first stage of the easing cycle, however, RBA officials probably will move more cautiously than before. We expect a 50bp rate cut in early December, and three 25bp rate cuts through the first half of 2009. Our forecast for the terminal cash rate remains 4%.

Our view is that Australia's economy is headed for a mild recession despite the RBA's bold policy moves. The aggressive rate cuts, coupled with the Government's "deployment" of the Budget surplus, will provide a cushion for the economy, not prevent recession. Indeed, we forecast a small drop in GDP in the current quarter and another in the first quarter of 2009 as Australia's economy gets caught in the downdraft from offshore. History tells us, though, that policy support does work, albeit with a lag. The domestic policy responses already in place, an expected rebound in global growth later in 2009, and the lower AUD explain why we believe this recession will be short and shallow, and much less painful than the extended recession of the early 1990s.

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